Tuesday, August 19, 2014
11:44:54 PM EDT

How Technical Analysts Can Get It Wrong

by
Leigh Stevens

During the sell off after the late-July Peak, some technically oriented traders and advisers were suggesting that we were or could be headed into a bear market. I treat such bold indicator based predictions with some skepticism.

This isn't to say that eventually there WON'T be predictions that correctly predict the onset of nearness of a bear market. I don't see such prospects now however as there are contrary reasons, also mostly technical (partially fundamental), why I was seeing ONLY a corrective pullback after the last Market peak.

What I heard so far, as to reasons why we hit a bull market peak and could be headed into a bear market, fell into two categories; these were only the things I heard:

1. LESS STOCKS PARTICIPATED IN THE LAST RALLY (A DIVERGENCE)

August 3rd news item -

"Mark Cook, a veteran investor included in Jack Schwagerâ€™s best-selling book, Stock Market Wizards and the winner of the 1992 U.S. Investing Championship with a 563% return, believes the U.S. market is in trouble.

The primary indicator that Cook uses is the Cook Cumulative Tick, a proprietary measure he created in 1986 that uses the NYSE Tick in conjunction with stock prices. His indicator alerted him to the 1987, 2000, and 2007 crashes. The indicator also helped to identify the beginning of a bull market in the first quarter of April 2009, when the 'CCT' unexpectedly went up, turning Cook into a bull.

There have been only two instances when the NYSE Tick and stock prices diverged radically, and that was in the first quarter of 2000 and the third quarter of 2007. The third time was April of 2014,â€ Cook says.

In simple terms, as stock prices have gone higher, the NYSE Tick has moved lower. This divergence is an extremely negative signal, which is why Cook believes the market is losing energy.
In fact, the Tick is showing a bear market, which seems impossible considering how high the market is rising."

TOO FEW HISTORICAL EXAMPLES

This may be one fallacy in the above prediction but he is basically saying I believe, that fewer stocks participated in the late-July rally (true) and this bearish technical divergence is so extreme (although based on a limited number of historical examples) as to predict that we're headed into a bear market.

ANOTHER SIMILAR ANALYSIS:

At the late-July peak, fewer and fewer stocks were trading above their 4-week moving averages. (This IS a characteristic of a bull market peak.)

However, the foregoing example of this phenomena is based on a low volume summer peak. We would need to see if this condition persists. I was noting, going into the late-July top, that fewer and Dow stocks were in strong uptrends and new highs in Dow was therefore suspect. I was however only suggesting that a pullback was in order so to speak.

ABOUT TECHNICAL DIVERGENCES

The prior examples of technical 'divergences' are similar to others such price/indicator pairings that go in different directions or in diverging trends.

For example, the major indexes rally to new highs or the same high but on less 'relative strength' as measured by the Relative Strength Index or RSI indicator which is similar to the percentage of stocks above their 4-week moving averages becoming fewer and fewer as prices go up to a higher high and a new top.

The 'tick' example is similar to one or more of the major indexes going up on increased selling pressure, as measured by the TRIN (Trading Index) stock market indicator, known more properly as the "Arms Index" after the inventor of this indicator.

The Arms Index or TRIN indicates whether MORE volume is flowing into advancing or declining stocks. TRIN readings ABOVE 1 indicate SELLING pressure. Conversely, readings below 1 indicate BUYING pressure. If stocks go to new highs but more volume is going into stocks that are declining rather than advancing stocks, this condition suggests that the rally is suspect; look out below! kind of a thing.

Below in my first chart, is an example of the Nasdaq Composite (COMP) going to its late-July peak (and a second 'double' top) on LESS relative strength strength, which is suspect. However, such price/indicator divergences in a major bull market are usually ONLY suggestive of a possible corrective pullback. In fact the pullback that followed was a 'minimal' (Fibonacci) 38% retracement of the prior advance before COMP broke out to new highs for the current move.

MEASURING A CONTINUING BULL MARKET TREND

Long-term charts measure the rate of price change over a multiyear period and, technically in chart terms, we see upside momentum and the rate of price increase by the simple device of a support/up trendline drawn through the various reaction lows as seen below in COMP. How do we measure that a pullback is only a correction and not a reversal? There are various rules of thumb, but one long-standing is highlighted below, as recent COMP support on a weekly chart basis was found in the area of the prior (March 2014) top.

ANOTHER EXAMPLE OF A PRICE/INDICATOR 'DIVERGENCE'

I already briefly described the Arms Index or TRIN technical indicator, and at the late-July top in the S&P and the (not often discussed) NYSE Composite Index (NYA) there was less buying of advancing stocks than there was selling in declining stocks. I use the NYSE Composite Index because the TRIN indicator is based on either the NYSE universe of stocks or the Nasdaq universe of stocks.

The technical divergence highlighted next is similar to the aforementioned Cook Cumulative Tick (CCT) model; the way it is described I believe this to be case. Moreover, the technical bearish price/TRIN divergence seen on my next chart is similar to fewer and fewer stocks going to new highs that are trading above their 4-week price average.

In any event, any ONE such bearish technical divergence such as seen above has to viewed in context of the bigger chart and trend picture and what we see below in the S&P 500 (SPX) is nothing more so far, than a pullback to SPX's long-term support (up) trendline. Of course, yet to come is a move to new SPX highs, but I think that's coming. Stay tuned!

I started out back in the beginning of this piece talking about another bearish influence that was being discussed by at least one prominent technically oriented market advisor, as something in a different category than price/indicator 'divergences' and it becomes #2 on my list of what was said to mark the possible END of the current Bull Market.

2. STOCK MARKET ADVISORS ARE 'TOO' BULLISH:

At Market tops, a very large percentage of investment advisors, as well as investors and traders, are bullish. HOWEVER, to say that say, 80% in a well-known survey are bullish. And that's suggesting a major bull market top is too simplistic; and simply not helpful in terms of when you should scale back stock levels or to take out put protection and the like. The simple reason for this is that high levels of investment advisor bullishness can and does go on for a LONG time in bull markets and you never know quite when a specific high level of bullishness will exactly mark the top of a bull market.

On the other hand, for us trader types, there is a call to put volume ratio indicator that is useful in predicting 'extremes' in bullishness that occur at tops; and more so, extremes in bearishness that tend to predict bottoms of bull market corrections within at least 5 trading days. A recent example of my daily CBOE volume ratio of daily equity call volume to total equity put volume. This ratio plotted in graph form is one I use to help in 'timing' trade entry (mostly outright call purchases), ALONG WITH concurring price an RSI patterns.